Emissions trading with rolling horizons

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In this paper the authors develop a model to evaluate first, the market developments in the European Union emissions trading scheme (EU ETS) over 2008–2017 ex-post and second, the performances of main features of the EU ETS reforms that took place in 2018, ex-ante.

These developments include the market stability reserve (MSR), a rule-based supply-side control unique of its kind: effective from January 2019, the MSR automatically adjusts the volume of annual allowance auctions based on the past market-wide allowance bank, the so-called total number of allowances in circulation.

The authors’ contributions are threefold. First, they enrich the archetypal allowance trading modelling framework to allow regulated firms to use rolling planning horizons to address uncertainty as well as to exhibit bounded responsiveness to the MSR (i.e. limited sophistication in their understanding of the interplay between their decisions and the MSR-driven supply shifts over time). Second, they show how a rolling finite horizon is able to reconcile the observed dynamics of the allowance bank with discount rates implied from futures’ yield curves; and better capture annually-averaged allowance price changes compared to conventional models.

Third, but not least, they use their calibrated model to evaluate the 2018 reform, separate out the impacts of its three main features – an increase in the linear reduction factor (LRF) of the cap, the introduction of the MSR, and its reinforcement with a cancellation mechanism (CM) – and quantify how they hinge on the firms’ horizon and responsiveness degree. In so doing, the authors highlight important implications for policy design and evaluation, some of which are summarised below.

Key points for decision-makers

A rolling horizon means that firms only make the most immediate decisions (i.e. in the first period) by optimising over a finite number of periods ahead for which they can make realistic forecasts about the relevant factors entering their decision-making. Only the first-period optimal decisions are implemented and the procedure repeats every period thereafter with updated forecasts over an equally long horizon.

The cancellation mechanism (CM) works by cancelling allowances in the MSR in excess of the number of auctioned allowances in the previous year.

The linear reduction factor (LRF) specifies the quantity by which the emissions cap (i.e. supply of allowances) declines on a yearly basis.

The price jump observed in 2018 is consistent with firms using a rolling horizon and being responsive to the implementation of the MSR, but crucially irrespective of the CM.

Taken separately, both the LRF increase and the introduction of the MSR raise prices and reduce the cumulative volume of authorised greenhouse gas emissions. Importantly, this holds even without the CM.

The impacts of the introduction of the MSR on cumulative emissions is largely independent of the LRF increase but crucially depends on the CM and on firms’ planning horizons and responsiveness to the MSR. For instance, the reduction in cumulative emissions can be substantial with the CM – in the order of 5 to 10 gigatonnes of carbon dioxide depending on the firms’ horizon.

The CM has negligible impacts on market outcomes in the first two to three decades. Its implementation essentially curbs cumulative emissions and reduces the intertemporal inefficiencies induced by the MSR.

The authors compute the extent to which the MSR can adjust cumulative emissions to partially reflect the interaction between the ETS and external factors affecting the allowance demand.

The modelling framework can serve as a good basis for an ex-post assessment of the MSR for the upcoming review of the EU ETS in 2021. It can also be used to analyse the impacts of changing the MSR parameters ex-ante or introducing an allowance price corridor – a more standard supply control – in place or on top of the MSR.

The modelling framework is amenable to amendments and calibration to other systems, for instance the Regional Greenhouse Gas Initiative in the United States or the linked California-Québec ETS where other forms of price corridors, intertemporal trading provisions and compliance cycles are in place.

An earlier version of this working paper was published in January 2019 under the title Intertemporal emissions trading and market design: An application to the EU ETS, which is available upon request.

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